A P: Foreign lessons on forex

We should learn a thing or two from the investment corporations of Abu Dhabi and Singapore

Despite some hiccups in the weeks post the election results, India's foreign exchange reserves have begun to slowly build up once again. The dollar continues to weaken globally and most currencies of the world, including the Indian rupee, are under pressure to appreciate against the greenback.

Given the trends in India's external sector, it seems quite clear that the country is in for a period of continuously rising reserves.

Everyone knows about the rapid growth in service sector exports as well as the strong and sustained inflows on account of remittances, all of which lead to a huge surplus on the invisibles side of the current account.

However, over and above this, I think what will surprise observers is the continued strong inflows on the capital account. The last two years have seen record inflows from foreign institutional investors (FIIs) of over $10 billion, and my sense is that there will be no serious let-up in this area.

The amount of equity issuance in India expected over the next 12""24 months""both from the corporate sector and the government""is unprecedented. I can easily count over 12 one-billion-dollar deals likely to hit the market.

With this type of capital raising the fate of the markets is debatable, but strong foreign inflows are pretty much a certainty. I think one will see a similar picture on the FDI side as well, with the government hopefully succeeding in its endeavour to attract substantial FDI into infrastructure.

The net result of all of the above is that one should expect the forex reserves of India to keep rising for the foreseeable future.

The trend will only get accentuated if the RBI were to actually implement full convertibility. In three years India may be sitting on forex reserves near $200 billion, China for comparison has already crossed $500 billion.

The obvious question then becomes as to how the country should manage this surplus. While there has been a lot of discussion in the popular press about using the reserves for infrastructure, I am talking here more about actually managing the reserves from a portfolio management point of view with an eye on financial returns.

From my limited understanding, I believe that currently our entire reserves are parked in sovereign fixed-income securities of various durations and currencies, but predominantly in the US fixed-income market.

This is perfectly logical, given the depth and liquidity of the US fixed-income market and the behaviour and investment profile of most central banks.

While logical, one has to keep in mind that it is difficult to earn much above 4 per cent on a basket of US fixed-income instruments, the dollar is dropping like a stone, and we are at the beginning of an interest rate tightening cycle. Not the best of times to be heavily exposed to the US sovereign debt markets.

But is there any other way? Isn't the behaviour of the RBI perfectly consistent with what we should expect from any conservative central bank? Most central banks in the region, similarly flush with reserves, are asking the same questions.

I would argue that the approach of a GIC (Government of Singapore Investment Corporation) or an ADIA (Abu Dhabi Investment Authority) offers an alternative.

The GIC and ADIA are among the smartest and most well-respected investment organisations in the world. One manages the foreign reserves of Singapore, the other the surplus oil wealth of Abu Dhabi, and both have more than $100 billion in assets (GIC yearbook).

They actively manage their reserves as any prudent portfolio manager would and have a balanced portfolio spread among equities, fixed income, currencies, and across geographies. They manage assets internally as well as give out mandates to external fund managers.

The advantages of this approach are manifold:

Employing modern portfolio management techniques and diversifying across asset classes and geographies, these institutions are able to add value and returns over the long term as compared to a portfolio entirely invested in debt instruments and that too mostly in the US.

They have been able to develop a pool of very talented and skilled professionals who fully understand global financial markets and are based in their home countries. This adds to the depth of local-market knowledge and experience.

By virtue of the mandates they hand out to other outside fund managers, they have developed Singapore/Abu Dhabi into regional fund management hubs.

If the Indian government were to set up an equivalent of the GIC/ADIA in India, similar advantages would flow.

An extra 2""3 per cent in returns (very possible using a balanced portfolio of debt and equity) per annum would translate into an additional $3""4 billion of income, which could be put to productive use.

Also, the depth of knowledge and experience of global markets would multiply exponentially among local market participants if such an institution were set up.

You would have a cadre of people dealing in global markets based in India for the first time, as well as the whole supporting set-up of brokers/intermediaries forced to understand global markets/instruments and best practices.

Initially, as its own internal fund management skills develop, the organisation will need to farm out the bulk of its assets. This process of farming out assets can attract global money management firms into India, who may have ignored the country otherwise.

It will also give Indian money management firms an opportunity to develop global fund management skills. All of the above will significantly increase the sophistication of domestic financial markets and institutions.

The issues of course boil down to:

1. Can the Indian government create an organisation as professional and free of government interference as a GIC or ADIA?

2. With a balanced portfolio of debt and equity, there will be the occasional years like 2001 and 2002 with strong negative absolute returns. Does the government have the stomach to handle this volatility?

I would argue on the first count that there are enough ways to firewall any new organisation from government interference, starting with the choice of board and chairman as well as the design of investment processes.

It can be done, and if the RBI is the sponsoring institution, this in itself will act as a shield from Delhi.

As for the second point, as long as one is clear that we are in a phase of constant reserve accumulation with no immediate need for drawdowns, one should be able to take a longer-term view of returns and their volatility.

As almost any study will show, over the long term there is very high probability that a balanced portfolio will outperform a pure fixed-income portfolio. Again, being under the purview of the RBI, hopefully this issue of returns and short-term volatility will not get politicised.

India has so many bright people in public service. The only reason we have not yet moved to a more active management of our reserves must be the fear of politicisation of the institution and victimicisation of individuals if returns were ever negative.

Isn't an additional $3""4 billion a year in returns enough of an incentive to find ways around this in a bipartisan manner?

Or is it that the powers that be are still not confident on the sustainability and quality of our external reserves?

That would be a sad commentary indeed, if, when the whole world has finally woken up to India's potential, we still refuse to believe in ourselves and our future.